Could Technological Innovations in Lit Markets Counter the Advantages Offered by Systematic Internalisers?

Concept

The Persistent Asymmetry in Modern Equity Execution

The contemporary equity market structure is not a monolithic entity but a complex ecosystem of competing execution venues, each governed by distinct protocols and transparency mandates. At the heart of this landscape lies a fundamental tension between two primary models ▴ the lit public exchanges and the more opaque, bilateral environment of Systematic Internalisers (SIs). Understanding the deep-seated operational advantages inherent to the SI model is the predicate for evaluating any technological countermeasure from lit markets. SIs, which are investment firms using their own capital to execute client orders, operate on a principle of internalization.

This mechanism allows them to function as the direct counterparty to a client’s trade, absorbing the position onto their own books, at least momentarily. The structural benefit of this arrangement is profound, primarily through the control of information. By containing a trade within its own architecture, an SI prevents the immediate dissemination of that order to the broader market, mitigating the price impact that is an unavoidable consequence of displaying large orders on a public exchange’s central limit order book.

This capacity for opacity is a powerful draw for institutional clients whose primary objective is the low-impact execution of substantial orders. The AMF’s research underscores the scale of this phenomenon, revealing that a significant portion of SI transaction volumes are not subject to pre-trade transparency requirements. This managed information leakage is the core value proposition. A lit market, by its very definition, operates on the principle of full pre-trade transparency, where all bids and offers are displayed for all participants to see.

While this fosters a robust and fair price discovery process for the market as a whole, it presents a tactical challenge for any single large participant who risks signaling their intentions and inviting adverse price movements from opportunistic traders, including high-frequency market makers. The competition between these two models is therefore a competition between two philosophies of execution ▴ the collective, transparent price discovery of the lit market versus the discreet, low-impact execution of the internalized model.

Systematic Internalisers derive their primary advantage from controlling information flow, offering discreet execution that minimizes the market impact inherent to transparent lit venues.

Defining the Competitive Terrain

The advantages offered by Systematic Internalisers extend beyond simple opacity and are rooted in the nuances of market microstructure and regulation. Historically, one of the most debated advantages was the tick size exemption. For a period, SIs were not bound by the same minimum price increments (tick sizes) as regulated exchanges. This allowed them to offer marginal, yet meaningful, price improvements to clients by quoting prices at increments smaller than what was permissible on the lit market.

For a broker bound by best execution mandates, routing an order to an SI that could provide even a fractional price improvement was not just an option but an obligation. While subsequent regulatory changes, such as the extension of the MiFID II tick size regime to SIs, have harmonized this particular aspect, the legacy of this capability established SIs as formidable competitors and created a “stickiness” in order flow, conditioning market participants to route significant volume through these channels.

Furthermore, the SI framework is bifurcated, catering to different segments of the market. The AMF report distinguishes between Bank SIs, which typically handle very large, often voice-brokered transactions, and Electronic Liquidity Provider (ELP) SIs, which are frequently high-frequency trading firms that execute smaller, automated orders. This specialization allows SIs to tailor their offerings. Bank SIs provide a high-touch, discreet service for block trades that would be impossible to execute on a lit order book without catastrophic price impact.

ELP SIs, conversely, use sophisticated algorithms and speed to provide competitive pricing and internalization benefits for the torrent of smaller orders that characterize modern markets. Lit markets, in contrast, must provide a one-size-fits-all solution, a centralized venue that serves retail brokers, institutional investors, and high-frequency traders simultaneously. This universal service model, while essential for a functioning market, is inherently less specialized than the client-centric model of an SI.

Strategy

Re-Architecting Lit Markets for a Fragmented World

The strategic response of lit markets to the challenge posed by Systematic Internalisers revolves around a multi-pronged technological and structural evolution. The objective is to replicate the core benefits of internalization ▴ namely, reduced market impact and competitive pricing ▴ within a regulated and centrally cleared framework. This involves moving beyond the traditional central limit order book and developing a more sophisticated suite of execution tools and protocols designed to manage the trade-off between transparency and execution quality. The overarching strategy is to enhance the lit market’s value proposition by integrating features that cater specifically to the needs of institutional participants who would otherwise turn to SIs.

A primary vector of this strategy is the development of alternative trading mechanisms that operate under the umbrella of the lit exchange but with different transparency rules. These are not entirely new concepts, but their technological enhancement and integration into the broader market ecosystem are accelerating. Block trading facilities, for example, allow for the pre-arrangement of large trades which are then reported to the exchange. Periodic auctions are another key innovation; these are frequent, short-duration auctions that aggregate liquidity at a single point in time, allowing for large volumes to be transacted at a single price without the risk of information leakage associated with resting a large order on the continuous order book.

These mechanisms directly counter the opacity advantage of SIs by providing a regulated, on-exchange alternative for executing large orders with minimized price impact. They represent a strategic admission that the one-size-fits-all model of the continuous lit book is insufficient for all market participants and that a segmented, technologically advanced approach is required.

The Central Role of Intelligent Order Routing

The fragmented nature of modern markets, with liquidity spread across lit exchanges, SIs, and various dark venues, has made the technology of order routing a critical battleground. Smart Order Routers (SORs) are the primary technological tool that lit markets and their participants can leverage to counter the advantages of SIs. An advanced SOR is an algorithmic system designed to dissect a large parent order into smaller child orders and route them intelligently across multiple venues to achieve the best possible execution.

Its strategy is to source liquidity wherever it may be found, minimizing costs and market impact. In doing so, a sophisticated SOR can replicate some of the benefits of internalization on a systemic level.

Lit markets counter the SI model by embedding discreet execution mechanisms and leveraging smart order routing to aggregate fragmented liquidity, effectively internalizing risk at a market-wide level.

The SOR’s strategy against SIs operates on several levels. First, it directly addresses the issue of price improvement. By simultaneously scanning the lit book, probing dark pools, and sending requests-for-quote to SIs, the SOR can algorithmically determine the venue offering the best net price at any given moment. Second, it tackles market impact by dynamically adjusting the size and timing of child orders based on real-time market conditions.

It can, for instance, route small, non-impactful orders to the lit book to capture available liquidity while directing larger, more sensitive portions of the order to periodic auctions or dark pools. This intelligent dissection and routing process is a technological counter to the SI’s ability to manage impact by simply containing the trade. The SOR, in effect, uses the entire market ecosystem as its internalization engine, achieving a similar outcome through superior technology and data analysis.

The table below outlines the strategic positioning of these lit market innovations against the core advantages offered by Systematic Internalisers.

Execution

The Operational Protocols of Advanced Execution

The execution of an institutional-sized order in the modern market is a complex, multi-stage process governed by sophisticated technological protocols. The decision to route an order to a lit market or an SI is not a simple binary choice but the outcome of a detailed transaction cost analysis (TCA) and the application of advanced execution algorithms. To effectively counter the SI advantage, lit markets have fostered an ecosystem of technologies that allow traders to execute with a level of nuance and control that approaches the discretion offered by an SI. This is achieved through a combination of algorithmic trading strategies, intelligent data processing, and new communication protocols that are embedded within the exchange architecture itself.

One of the most potent tools in this arsenal is the suite of advanced order types available on modern exchanges. These are not the simple market or limit orders of the past. An “iceberg” order, for instance, allows a participant to display only a small fraction of their total order size on the public book, replenishing the displayed portion as it is executed. This directly mitigates information leakage, mimicking the opacity of an SI.

“Pegged” orders can be programmed to automatically adjust their price relative to the national best bid or offer (NBBO), allowing a trader to passively source liquidity without having to manually update their order. These and other algorithmic order types are the building blocks that a trader or a Smart Order Router uses to construct a sophisticated execution strategy, allowing them to interact with the deep liquidity of the lit market while carefully managing their information footprint.

A Comparative Analysis of Execution Venues

The choice of execution venue is ultimately a function of the specific order’s characteristics and the trader’s objectives. The table below provides a granular comparison of the operational attributes of different execution venues, illustrating the trade-offs involved. The data on SI transaction sizes is conceptual, based on the distinction between Bank and ELP SIs noted in the AMF report.

The operational decision of where to route an order is a dynamic calculation of trade-offs between the explicit costs of execution and the implicit costs of information leakage.

The Unintended Consequences of Parity

The effort to create a level playing field between lit markets and SIs can have complex and sometimes counterintuitive consequences. The academic research on the extension of the tick size regime to SIs in Sweden provides a compelling case study. The expectation was that by removing the SI’s ability to offer sub-tick price improvement, order flow would migrate back to the more transparent lit exchanges, improving their market quality.

The study, however, found the opposite to be true ▴ market quality on the lit exchange deteriorated. Spreads widened, and the price impact of trades increased.

The explanation for this phenomenon lies in the behavior of different types of traders. SIs, with their ability to offer fast execution and slight price improvements, were particularly attractive to “impatient” or “liquidity-consuming” traders. These are often informed traders who value speed and certainty of execution over obtaining the absolute lowest price, and their trading style tends to absorb available liquidity. When the tick size advantage was removed, these impatient traders were forced to route more of their aggressive orders to the lit market.

This influx of liquidity-consuming order flow overwhelmed the available liquidity provided by market makers, leading to wider spreads and a general degradation of market quality. This finding is crucial because it demonstrates that a simple technological or regulatory parity is not a guaranteed solution. It highlights that SIs can play a role in segmenting order flow in a way that, perhaps unintentionally, protects the lit markets from the most aggressive, impact-full orders. The key takeaway is that the different venues in the market ecosystem are deeply interconnected, and a change in one part of the system can have unforeseen effects on the others. Therefore, the strategy for lit markets cannot simply be to eliminate the advantages of SIs, but to build a resilient and diverse ecosystem that can effectively absorb and manage all types of order flow.

The following list outlines the execution workflow for an institutional order using a modern, technologically advanced brokerage platform, demonstrating how these different venues are integrated:

1. Order Ingestion ▴ The process begins when a large parent order (e.g. buy 500,000 shares of XYZ) is entered into the Execution Management System (EMS).
2. Pre-Trade Analysis ▴ The system’s TCA module analyzes the order size relative to the stock’s average daily volume, volatility, and current market conditions. It recommends an execution strategy, such as a percentage of volume algorithm.
3. SOR Configuration ▴ The trader configures the Smart Order Router, specifying which venues to access (lit books, specific dark pools, periodic auctions) and the parameters for the execution algorithm (e.g. maximum aggression level, start and end times).
4. Passive Execution Phase ▴ The SOR begins by placing passive child orders (e.g. iceberg orders) on the lit book to capture liquidity from incoming market orders. It simultaneously listens for opportunities in dark pools.
5. Active Execution Phase ▴ As the execution progresses, if the algorithm falls behind its schedule, it may become more aggressive. It might increase the displayed size of iceberg orders or send immediate-or-cancel (IOC) orders to sweep the lit book. It will also route portions of the order to any upcoming periodic auctions.
6. SI Interaction ▴ Throughout the process, the SOR may also send requests-for-quote (RFQs) to a select group of SIs to see if they can offer a better price for a portion of the order than what is available on the public markets.
7. Continuous Optimization ▴ The algorithm continuously monitors execution prices and market impact, adjusting its strategy in real-time. If it detects that its own orders are causing adverse price movements, it will slow down its execution rate.
8. Completion and Post-Trade Analysis ▴ Once the parent order is filled, the system generates a detailed post-trade report, comparing the execution performance against various benchmarks (e.g. VWAP, arrival price) and providing a full breakdown of which venues were used.

Reflection

Beyond a Level Playing Field

The examination of market structure reveals that the interplay between lit venues and Systematic Internalisers is governed by a logic deeper than a simple rivalry for order flow. It is a dynamic system of trade-offs, where the value of transparent, collective price discovery is constantly weighed against the need for discreet, low-impact execution. The technological advancements within lit markets are not merely tools to win a zero-sum game; they are adaptations that enrich the entire market ecosystem. They provide participants with a more granular set of choices, allowing for the precise calibration of execution strategy to specific objectives.

The ultimate goal of this evolution is not the dominance of one model over the other, but the creation of a more resilient and efficient total market architecture ▴ a system that offers robust pathways for execution, regardless of an order’s size or urgency. The strategic imperative for any market participant is to understand this system in its entirety and to build an operational framework capable of navigating its complexities to achieve a consistent execution advantage.